The cost and availability of indemnification of beneficial owners by securities lenders is a perennial topic at conferences. But it is not clear that the dire warnings about cost and availability have really come to pass. There is a developing trend in sec lending that could change all this. It is the shift toward more non-cash collateral. These trades absorb more RWA (than cash collateralized deals) and could put agent indemnification into play.
Recent rules on how much RWA sec lending indemnifications absorbs made those indemnifications more expensive for agents. Under Basel I VaR analysis was used and the exposure was virtually non-existent. From a State Street paper “The Value and Cost of Borrower Default Indemnification” (November 2013):
“…Under Basel I, with exemptions provided by the Federal Reserve and the Office of the Comptroller of the Currency, many banks utilize a Value at Risk calculation to determine the RWA associated with securities lending. The risk weighting for banks and broker/dealers under Basel I is 20%, so the agent lender bank then multiplies its calculated VaR by 20% to arrive at RWA…”
With Dodd-Frank, this calculation was replaced. From the same State Street paper:
“…As U.S. banks adopt Basel III, the Collins Amendment within DFA will require large banks to calculate regulatory capital ratios using both an advanced and standardized approach and to apply the more conservative of the two. Under a standardized approach, banks will need to use static haircuts rather than VaR modeling. Further, as proposed, the risk weighting for broker/dealers will be 100%…”
But even so, it seems like most sec lending agents chalked it up as a cost of doing business. Indemnification costs for cash collateral trades – the common form in the US – was fairly benign. Certainly banks were not happy eating the extra cost, but it looked like they had inadequate pricing power to do much about it.
An August 2014 State Street report “Capital Cost Implications of Pending and Proposed Regulatory Changes” illustrates the RWA absorbed by lending agents (and prime brokers) for different combinations of borrowed asset and collateral. It shows that, for example, a sovereign bond vs. cash trade uses just 10% of the RWA of an S&P 500 stock vs. a sovereign bond or just 6% of the RWA of an S&P 500 stock vs. another S&P 500 stock trade. If lending agents contain the non-cash business and/or more volatile underlying securities, they can minimize indemnification costs.
So what has changed? According to the most recent International Securities Lending Association report (and verified by sec lending traders) the proportion of non-cash collateral is rising. We wrote about this in our September 16, 2015 post “ISLA’s 3rd Securities Lending Market Report shows an industry adapting well to market and regulatory changes”. From that report:
“…The drift towards the use of non-cash collateral across the industry continued. The proportion of loans collateralised with non-cash collateral increased to 60% of all transactions, up from 55% six months earlier. Fixed income government bond lending continued to record much higher levels of non-cash collateral with, for example, 90% of all European government bond loans being collateralised with other securities…”
“…Further analysis of the data also reveals that although the overall level of North American bond lending rose by circa 10% non-cash collateral balances actually increased by 35% as cash collateral balances fell by 11% during the period…”
Furthermore, there has been a lot of growth in the use of equities as collateral. Equities, as the table above illustrates, are more RWA intensive than cash or sovereign paper. This is part and parcel with banks using securities lending as a balance sheet efficient way of executing collateral upgrade trades necessary to manage their LCR (and eventually NSFR).
So if non-cash collateralized trades absorb more RWA than cash trades, and the drift is toward more non-cash trading (and especially those using equities), then the overall RWA and capital cost of indemnification will rise. The big question is when will RWA become a binding constraint on sec lending agents? Some have said this is starting to happen. If the trend continues – and there is no reason to think it will abate – then indemnification will once again be a hot topic. Will this force a shift in pricing power back to the agents? Can CCPs ease the pain enough to convert the skeptics? Watch this space….